Might as well start with the basics. Cyprus is an island in the eastern portion of the Mediterranean sea. The northern half of the island is primarily populated by Cypriots of Turkish origin, while the south is dominated by Greek Cypriots. After nearly a century as a British colony (following an even longer period under the control of the Ottoman Empire), the island became independent in 1960, with a fragile power-sharing arrangement in place between Greek and Turkish residents. That broke down in 1963, and a U.N. peacekeeping force was sent to maintain order.
A decade-long period of inter-sectarian violence followed, with the Greek and Turkish governments intervening on behalf of their ethnic brethren, resulting in considerable population displacement. In 1974, the military junta governing Greece executed a coup d'état, deposing the Cypriot president and replacing him with a dictator who supported Greek annexation of Cyprus. Turkey responded by invading the island and executing an ethnic cleansing campaign against Greek residents of the north (where they were the majority at the time). The conflict ended with the island divided between a Turkish-occupied north and a Greek-dominated south, with the United Nations policing the border.
That situation persists to this day, with the U.N. peacekeeping operation set to mark its 50th anniversary next year. The Turkish Republic of Northern Cyprus, a puppet state recognized by no country other than Turkey, rules the north, while the Republic of Cyprus governs the south.
So there are two Cypruses? Then which one's in the E.U.?
The Republic of Cyprus — or the southern, Greek one, joined the European Union in 2004, and -- in a spectacular display of poor timing -- joined the euro zone in January 2008, just before the crisis hit. The E.U. has stated that the northern part of the island rightfully belongs to the Republic of Cyprus, and said that it considers Turkey an illegal occupier.
How's Cyprus been holding up during the crisis thus far?
Pretty well, actually. As the above chart shows, Cyprus' recession was much milder than that in the rest of the euro zone, and for most of the past five years Cyprus has outpaced its neighbors when it comes to growth.
Greece happened. Cypriot banks were heavily exposed to the Greek debt crisis, by virtue of having large bonds holdings of Greek debt, both public and private. The value of that debt took a nosedive, destroying the balance sheets of Cypriot banks. Cyprus Popular Bank had €3.4 billion in Greek government debt, and the Bank of Cyprus €2.4 billion; they ended up losing
€2.5 billion and €1 billion, respectively.
When Greek government debt was written down as part of a deal in 2011, that wiped out a lot of the remaining value of Greek debt. Popular Bank lost 76 percent of the value of their Greek bond holdings in the deal.
How did the banks deal with losing all that money?
They didn't, and, fearing the worst, the Cypriot government nationalized Popular Bank. The Bank of Cyprus requested assistance too.
How could the government afford that?
It couldn't; interest rates have spiked to 7 percent on long-term debt, which means that paying for all these bailouts is getting difficult for the Cypriot government. That's why the Bank of Cyprus's request, and the continued struggles of the nationalized Popular Bank, forced Cyprus to go to the Troika (that is, the European Commission, ECB, and IMF) in pursuit of a bailout covering both the government's financial needs, and the shortfalls faced by its largest banks.
How did the original bailout plan work?
Under the original plan, a number of people, including, most controversially, the people who put money in Cypriot banks, would fund the bailout. Deposits of €100,000 or less would have been subject to a 6.75 percent levy, and any deposits greater than that would have been taxed at a rate of 9.9 percent. That raises €5.8 billion, or more than half of the bailout. The proposal was basically an across-the-board tax on bank deposits. That's better for Cypriots than the alternative of just raising taxes a lot, because a large share of deposits in Cypriot banks are from foreigners, in particular Russians. But with a vote on the bailout proposal by Cyprus's parliament delayed until Tuesday, Cypriots were rushing to the banks on Monday to pull out their cash.
In exchange for instituting the levy, the Cypriot government would get €10 billion from the IMF and EU institutions to fund its banks and government. The proposal is especially painful because Cypriots' deposits are supposed to be insured by the government, meaning that depositors are guaranteed the right to withdraw whatever they put in. Obviously, that would no longer be possible if deposits are subject to a levy.
First, the plan was changed to exempt the first €20,000 of deposits, and then it was decisively rejected by the Cypriot parliament. Now any bank haircut appears dead in the water.
What do Russian mobsters have to do with all this?
Spotting an opportunity to curry favor with a strategically situated island nation, Russia offered Cyprus a €2.5 billion loan at 4.5 percent interest, well below prevailing market rates. As recently as two days ago it offered to make the terms even more generous. So what does Russia get in exchange?
A blind eye, more or less. For one thing, Cyprus has been letting Russia use it to funnel weapons to the Syrian regime, in flagrant violation of an E.U. embargo against the country. But it also has allowed Russian companies to set up Cypriot subsidiaries which can evade Russia's heavy taxes on companies that earn money abroad. That has provoked accusations that Cyprus is turning into a haven for Russian tycoons who want to launder dirty money. According to German intelligence, at least €20 billion of Cyprus' €70 billion in bank deposits come from Russia, much of it from the country's "oligarchs" who got rich through quasi-legal means in the chaos that followed the Soviet Union's collapse.
One advantage to the original bailout scheme is that the bank deposit tax would have hit these oligarchs as much as it will native Cypriots. The Russian deposits would haven taken a hit of between €1 and 2 billion under the bank deposit levy, a substantial fraction of the bailout's cost.
Where does the bailout stand now?
A plan with a haircut seems untenable, but the European Central Bank has threatened to cut off funds to Cypriot banks on Monday unless agreement is reached on how to raise €15.8 billion in bailout money. So Cypriot legislators are working over time to put a package together, knowing that failure would likely lead the Cyprus Popular Bank, the island's second largest bank, to fail, with devastating consequence, including, perhaps, Cypriot exit from the European Union.
What would a new bailout look like?
It could take any number of forms, most likely a long-term austerity plan from Cyprus totaling €5.8 billion over a number of years. It could also include a forced conversion of deposits to other assets, for example certificates of deposit, which would guarantee that funds stay in Cypriot banks for the foreseeable future. For example, the plan being considered by Cyprus's parliament right now raises the money through emergency bond sales and nationalization of pensions. But the Troika has expressed disapproval of that plan.
There was speculation it could also come from a different source than the EU, most plausibly the Russian government. But Russia has ruled that out, at least without EU participation.
What's the best case scenario from a bailout?
The best we can hope for is that Cyprus takes the hit, gets some money, recapitalizes its banks, and recovers from there. It had a fairly conservative banking sector before the crisis, with deposits far outstripping loans, and its government was actually running surpluses, so it doesn't have to engage in the kinds of fundamental structural reforms that appear necessary in Greece. So if the Greek losses were just a temporary shock, the rescue money should get the country back on its feet.
And the worst-case scenario?
The worst-case scenario under a plan with a haircut is that the plan triggers a run on banks not just in Cyprus (that appears to already be happening) but in other vulnerable countries like Spain and Italy as customers worry that the E.U. will try to impose similar conditions there. That would exacerbate an already bad situation as it would increase bank shortfalls; fewer deposits, after all, mean a worse deposit-to-liability ratio. Those kinds of runs could lead to a continent-wide crisis of the kind observers have been fearing since the euro zone started its slow-motion collapse back in 2009.
However, the failure of the initial haircut plan renders this outcome less likely. It does render a Cypriot exit from the monetary union quite a bit more likely. That would trigger bank runs in Cyprus as people try to get their money out before the Cypriot pound falls dramatically in value relative to the Euro, and could trigger further runs in Spain and Italy. That's bad for the same reason haircut-inspired bank runs are bad.
The original version of this post erroneously alluded to a U.N. embargo on Syria; no such embargo is in place. We regret the error.